Risk-layering and optimal insurance uptake under ambiguity: With an application to farmers exposed to drought risk in Austria.

Many risks we face today will very likely not stay the same over time. For example, it is expected that climate change will alter future risks of natural disaster events considerably and, as a consequence, current risk management and governance strategies may not be effective anymore. Large ambiguities arise if future climate change impacts should be taken into account for analyzing risk management options today. Risk insurance, while albeit only one of many risk management actions possible, plays an important role in current societies for dealing with extremes. A natural starting point for our analysis is therefore the question of how ambiguity may be incorporated in a world with changing risks. To shed light on this question, we study how ambiguity can affect the uptake of insurance and risk mitigation within a risk-layer approach where each layer is quantified using distortion risk measures that should reflect the risk aversion of a decisionmaker toward extreme losses. Importantly, we obtain a closed-form solution for such a problem statement which allows an efficient numerical implementation. We apply this model to a case study of drought risk for Austrian farmers and address the question how ambiguity will affect the risk layers of different types of farmers and how subsidies may help to deal with current and future risks. We found that especially for small-scale farmers the consequences of increasing risk and model ambiguity are pronounced and subsidies are especially needed in this case to cover the high-risk layer.

Mapping the effects of drought on child stunting.

As climate change continues, it is expected to have increasingly adverse impacts on child nutrition outcomes, and these impacts will be moderated by a variety of governmental, economic, infrastructural, and environmental factors. To date, attempts to map the vulnerability of food systems to climate change and drought have focused on mapping these factors but have not incorporated observations of historic climate shocks and nutrition outcomes. We significantly improve on these approaches by using over 580,000 observations of children from 53 countries to examine how precipitation extremes since 1990 have affected nutrition outcomes. We show that precipitation extremes and drought in particular are associated with worse child nutrition. We further show that the effects of drought on child undernutrition are mitigated or amplified by a variety of factors that affect both the adaptive capacity and sensitivity of local food systems with respect to shocks. Finally, we estimate a model drawing on historical observations of drought, geographic conditions, and nutrition outcomes to make a global map of where child stunting would be expected to increase under drought based on current conditions. As climate change makes drought more commonplace and more severe, these results will aid policymakers by highlighting which areas are most vulnerable as well as which factors contribute the most to creating resilient food systems.

Traces of business cycles in credit-rating migrations.

Using migration data of a rating agency, this paper attempts to quantify the impact of macroeconomic conditions on credit-rating migrations. The migrations are modeled as a coupled Markov chain, where the macroeconomic factors are represented by unobserved tendency variables. In the simplest case, these binary random variables are static and credit-class-specific. A generalization treats tendency variables evolving as a time-homogeneous Markov chain. A more detailed analysis assumes a tendency variable for every combination of a credit class and an industry. The models are tested on a Standard and Poor's (S&P's) dataset. Parameters are estimated by the maximum likelihood method. According to the estimates, the investment-grade financial institutions evolve independently of the rest of the economy represented by the data. This might be an evidence of implicit too-big-to-fail bail-out guarantee policies of the regulatory authorities.

Dependency of Crop Production between Global Breadbaskets: A Copula Approach for the Assessment of Global and Regional Risk Pools.

As recent events have shown, simultaneous crop losses in different parts of the world can cause serious risks to global food security. However, to date, little is known about the spatial dependency of lower than expected crop yields from global breadbaskets. This especially applies in the case of extreme events, i.e., where one or more breadbaskets are experiencing far below average yields. Without such information, risk management approaches cannot be applied and vulnerability to extremes may remain high or even increase in the future around the world. We tackle both issues from an empirical perspective focusing on wheat yield. Interdependencies between historically observed wheat yield deviations in five breadbaskets (United States, Argentina, India, China, and Australia) are estimated via copula approaches that can incorporate increasing tail dependencies. In doing so, we are able to attach probabilities to interregional as well as global yield losses. To address the robustness of our results, we apply three different methods for constructing multivariate copulas: vine copulas, ordered coupling using a minimax approach, and hierarchical structuring. We found interdependencies between states within breadbaskets that led us to the conclusion that risk pooling for extremes is less favorable on the regional level. However, notwithstanding evidence of global climatic teleconnections that may influence crop production, we also demonstrate empirically that wheat production losses are independent between global breadbaskets, which strengthens the case for interregional risk pooling strategies. We argue that through interregional risk pooling, postdisaster liabilities of governments and international donors could be decreased.

Structured Coupling of Probability Loss Distributions: Assessing Joint Flood Risk in Multiple River Basins.

Losses due to natural hazard events can be extraordinarily high and difficult to cope with. Therefore, there is considerable interest to estimate the potential impact of current and future extreme events at all scales in as much detail as possible. As hazards typically spread over wider areas, risk assessment must take into account interrelations between regions. Neglecting such interdependencies can lead to a severe underestimation of potential losses, especially for extreme events. This underestimation of extreme risk can lead to the failure of riskmanagement strategies when they are most needed, namely, in times of unprecedented events. In this article, we suggest a methodology to incorporate such interdependencies in risk via the use of copulas. We demonstrate that by coupling losses, dependencies can be incorporated in risk analysis, avoiding the underestimation of risk. Based on maximum discharge data of river basins and stream networks, we present and discuss different ways to couple loss distributions of basins while explicitly incorporating tail dependencies. We distinguish between coupling methods that require river structure data for the analysis and those that do not. For the later approach we propose a minimax algorithm to choose coupled basin pairs so that the underestimation of risk is avoided and the use of river structure data is not needed. The proposed methodology is especially useful for large-scale analysis and we motivate and apply our method using the case of Romania. The approach can be easily extended to other countries and natural hazards.

Assessing water resource system vulnerability to unprecedented hydrological drought using copulas to characterize drought duration and deficit.

Global climate models suggest an increase in evapotranspiration, changing storm tracks, and moisture delivery in many parts of the world, which are likely to cause more prolonged and severe drought, yet the weakness of climate models in modeling persistence of hydroclimatic variables and the uncertainties associated with regional climate projections mean that impact assessments based on climate model output may underestimate the risk of multiyear droughts. In this paper, we propose a vulnerability-based approach to test water resource system response to drought. We generate a large number of synthetic streamflow series with different drought durations and deficits and use them as input to a water resource system model. Marginal distributions of the streamflow for each month are generated by bootstrapping the historical data, while the joint probability distributions of consecutive months are constructed using a copula-based method. Droughts with longer durations and larger deficits than the observed record are generated by perturbing the copula parameter and by adopting an importance sampling strategy for low flows. In this way, potential climate-induced changes in monthly hydrological persistence are factored into the vulnerability analysis. The method is applied to the London water system (England) to investigate under which drought conditions severe water use restrictions would need to be imposed. Results indicate that the water system is vulnerable to drought conditions outside the range of historical events. The vulnerability assessment results were coupled with climate model information to compare alternative water management options with respect to their vulnerability to increasingly long and severe drought.

Refocusing disaster aid.

With new modeling techniques for estimating and pricing the risks of natural disasters, the donor community is now in a position to help the poor cope with the economic repercussions of disasters by assisting before they happen. Such assistance is possible with the advent of novel insurance instruments for transferring catastrophe risks to the global financial markets. Donor-supported risk-transfer programs not only would leverage limited disaster-aid budgets but also would free recipient countries from depending on the vagaries of postdisaster assistance. Both donors and recipients stand to gain, especially because the instruments can be closely coupled with preventive measures.

Infrastructure in developing and transition countries: risk and protection.

This article examines two possible strategies for financing post-disaster infrastructure rehabilitation in developing and transition countries: relying on ex ante financing instruments (including insurance, catastrophe bonds, and other risk-transfer instruments) and ex post borrowing or credit. Insurance and other ex ante instruments will increase a country's stability, especially if the government authorities have a difficult time borrowing or otherwise raising funds after a major disaster; however, these instruments have an opportunity cost and can reduce the country's economic growth potential. The cost-benefit tradeoff is therefore one between economic growth through infrastructure investment and added solvency and stability for the economy. This article develops a model to illustrate this tradeoff. The model, which views the infrastructure of a developing or transition country as a nondiversifiable portfolio that generates returns, can provide a basis for evaluating alternative financing options depending on the country's objectives in terms of growth, solvency, and stability.